The AD-AS Model

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[1]After looking at the macroeconomy in the short run, we now move on to looking at the economy in the long run, the advantage of which is the inclusion of inflation effects on output. This article looks at the effects of inflation on the economy and how the RBA responds to changes in inflation rates.

Textbook Readings

The AD Curve

Aggregate Demand as a Function of Inflation

[2]By contrast to the short run Keynesian model, in the long run, we assume that companies change prices in order to meet demand. This has the added effect of inflation, where increased demand increases inflation, which then lowers aggregate demand. The overall result is that demand is a downward sloping relationship to inflation.

Explaining the Downward Slope

The RBA's decision to increase interest rates in order to maintain low levels of inflation. They do this so that higher interest rates dampen spending and investment, effectively reducing aggregate demand and hence stops firms from inflating prices

Higher inflation reduces the real value of net assets. Hence households are less likely to spend which again reduced aggregate demand

Higher inflation means that selling to foreign markets (exports) declines as it is more expensive for foreign markets to purchase domestic goods. Since exports are part of aggregate expenditure, a decline in exports means a decline in overall spending and hence demand.

The connection between inflation and output is that higher inflation leads to lower demand and hence to lower output.

Shifts in AD Curve

[4]From the mathematical analysis above, it can be seen that the AD curve shifts due to:

Shifts in exogenous factors

Shifts in the RBA's reaction function (f)

In general, increases in the exogenous factors tend to shift the AD curve outwards[5] while increases in the reaction function (f) tend to shift the AD curve inwards[6].

Inflation and Supply Decisions

[7]So far, the discussion has revolved around the relationship between inflation and demand but has had no implication for economists. In this section, we try and find a model to describe inflation better with the goal of finding policies to control it.

Inflation Inertia

[8]Inflation inertia refers to the tendency of inflation to remain constant from period to period. That is, inflation tends to remain at around 2%-3% (in Australia) every year, unless one of the following occurs:

An Output Gap Occurs: If an expansionary gap exists, then inflation tends to increase

Inflation Shock: A rapid increase in the price of a commodity can have the effect of raising prices of other commodities

Shock to Potential Output: If for some reason potential output changes, such as a natural disaster, can cause the inflation rate to change

Together these are known as aggregate supply shocks.

[9]However without these shocks, inflation tends to remain at a constant rate. There are two main reasons for this:

Inflation Expectations- People's expectations of what inflation will be affect how much more they will be willing to spend next year for the same commodities. For example an expectation that inflation woud be 3% would mean that people will only e willing to spend an extra 3% on their groceries. On an economy wide scale, if the expectations are roughly the same, then companies will only increase prices by that amount and hence the expectations inform the actual inflation rate.

Long Term Wage and Price Contracts- similar to inflation expectations, when people sign contracts, they expect the wages to increase over the period of the contract to match with inflation. Hence inflation expectation comes in. Now companies that sign these contracts would increase prices by the same amount that they increase their payments to employees to cover all their costs and hence inflation lines up with expectations.

Output Gap and Inflation

Expansionary Gap (y-y*>0): In this situation firms are over their normal rate and hence choose to increase prices. This leads to higher inflation.

Zero Gap (y=y*): In this case the economy is at equilibrium and inflation remains constant (but is not zero! this is due to the inertia effect)

Contractionary Gap (y-y*<0): In this situation, firms are selling below their expectations and hence decide to decrease prices to sell more. Hence inflation will decrease.

Aggregate Demand- Aggregate Supply Diagram

AD-AS Curve

[11]The relationship between inflation and output can be shown through the AD-AS (Aggregate Demand-Aggregate Supply) Curve. The curve consists of three lines, explained as:

Aggregate Demand- downward sloping with inflation, as explained above

Short Run Aggregate Supply (SRAS) - this line if flat since in the short run prices are seen to be constant, hence inflation is constant (but not zero, due to inflation inertia)

Long Run Aggregate Supply (LRAS) - this line is perfectly vertical and it corresponds to potential output. If we assume that potential output is the level of supply of goods when firms are operating at normal rates, and that it is where firms wish to be in the long run, then this line can be said to be the long run aggregate supply curve.

Now in order to understand how the relationship between output and inflation, lets assume that the economy is undergoing an expansion i.e. y>y*. This is the situation shown in the graph above. Now short run equilibrium occurs where PAE equals output, but in this graph it occurs where the AD and SRAS curves intersect. This is because the SRAS curve coincides with constant inflation rates, and hence where it meets the AD curve yields the point of actual output. However potential output is the LRAS curve, so notice that in the above graph, LRAS is to the left of the point of intersection between the SRAS and AD curves, i.e. y<y*, corresponding the an expansionary gap. Now in order to reach long run equilibrium, we need the point where LRAS and AD curves meet, which corresponds to a higher inflation rate. Over time, the economy will travel along the AD curve to meet LRAS and with it the SRAS curve will shift upwards. The point of equilibrium for the economy then is where all three lines intersect.

Inflation Shocks

[12]As described before, inflation shocks are periods where inflation rates increase dramatically. This can be due to shocks to potential output, or due to sudden increase in demand. While shocks to potential output correspond to sideways shifting of the LRAS curve, increased demand simply means shifting of the AD curve. These shifts can then be used to find the new levels of inflation.

Controlling Inflation

[13]In order to control inflation, the RBA has only the option of changing the cash rate, which in turn will affect the AD curve. In order to reduce demand and shift the AD curve to the left (and thereby reducing inflation), the RBA needs to increase interest rates. However this is often accompanied with introducing a recession (an output gap) in the short run as well as increasing unemployment (due to Okun's Law).